Transcript FONTERRA – BEYOND 2004

FONTERRA:
CAPITAL ISSUES
Agrivision Group
www.tonybaldwin.co.nz
15 March 2007
Context
This presentation followed an address by
Graham Stuart, Fonterra’s Director, Strategy
and Growth
Rather than present these slides, I engaged
in a discussion with the Agrivision meeting.
I referred to particular slides where relevant
to the discussion
2
Fonterra’s view
“There are a few zealots like Tony Baldwin, who
seem philosophically bent on sounding the death
knell of co-operatives....
Graham Stuart – Taranaki Daily News, October 2004
It is a shame that supposed leaders like Graham
resort to uninformed name-calling and old industry
prejudices – instead of openly addressing the real
issues
3
My approach
• I have no ideological views about cooperatives
“[Cooperative forms are] not anomalies, but
competitive institutions that form an integral part of a
healthy market economy”
Bengt Holmstrom, Prof of Economics at Massachusetts Institute of Technology
• Structure follows strategy. Some strategies can be
best achieved by cooperatives
4
Key question
The key question is – does F’s current
structure fit its claimed strategy?
The answer is almost certainly no.
5
What are you?
“ We are a dairy farmers' co-operative.
And we are a multinational marketing company.
And we are also an international capital investor”
Graham Stuart, 2002
Is this how you see Fonterra?
6
What are your goals for Fonterra?
• Maximise payout?
• Keep exclusive farmer control?
• Stay a co-op?
7
Why a co-op?
• But why a co-op? Why 100% control?
– To guarantee milk pick up and processing, and
– To guard against non-supplier shareholders
‘squeezing’ milk price to get more profits
• But Fonterra wants more capital than you can
provide and a more stable balance sheet
• Serious proposal for outsider shareholders
• Need to find other ways of addressing the two
concerns above
8
Key problem
Traditional producers co-ops do not
normally work out a net profit. They
simply split their ‘surplus’ into ‘payout’
and ‘retentions’
Payout
So the core issue comes down to
separating ‘payout’ into ‘raw milk
price’ and ‘dividend’ in order to work
out ‘net profit’
Raw
milk
price
With no farm gate
competition, outside
investors could try to
‘squeeze’ the raw milk
price to get more profits
Co-op’s
‘surplus’
Dividend
Net
profit
Retained
Retained
9
Options
• Options to address this problem include:
– Long term milk supply contracts – with guarantees
of milk collection, and
– Independent rules to set a milk price that outside
shareholders can’t ‘squeeze’, or
– Help create more farm-gate competition – so you
get a real raw milk price
10
Co-op philosophy
“At the heart of the Cooperative Philosophy
is the distribution of wealth between
shareholders”
From Fonterra/shareholders’ constitutional documents
But what matters more – growing wealth or
keeping control?
11
REVENUE
MergerGROWTH
Vision
Over 10 years:
• Grow capital from $10b to $30b
• Grow revenues at 15% pa
• Deliver 15% pa return on gross assets
$ Millions
35,000
30,000
$19 billion in new sales
from ‘non-commodities’
– like pharmaceutical,
health foods and
specialised ingredients
25,000
20,000
15,000
10,000
$11 billion from core
(commodity) business
5,000
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93
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98
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99
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00
20
01
20
02
20
03
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04
20
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06
20
07
20
08
0
Source: Industry Leaders’ Presentation
12
Gains since 2001
• Integrated management and systems
• Some cost reductions
• Closer linkage between production and customers
• Better inventory management (decrease from 34% to
24% as % of annual sales volume)
• Improved supplier services
• Some gains in monitoring (‘fair value’ share and
CMP processes)
13
Key capital problems
• Redemption risk
• Compulsory investment risk
• Insufficient shareholder funds
• Inefficient governance structure
14
Redemption risk
• Suppliers withdrawing at the same time
• Also involves loss of milk volumes required to cover
fixed asset costs
• Also risk of ‘regional cherry picking’
“It is possible, even probable, that Fonterra will be
faced with a declining share of the NZ milk
supply, say 75-80% compared to 96% at present”
Dr Alan Frampton, 2002
15
Compulsory investment
• NZ suppliers are forced to invest in non-NZ milk or
non-processing activities
• But you are likely to get better risk adjusted returns
over time from investing in a diversified portfolio of
investments
16
Compulsory investment
(cont’d)
• Fonterra obtains shareholder funds without having to
compete in the capital market, so it has less
incentive to use funds to return maximum yields over
time
• Fonterra should pay a higher return to compensate
for the higher risk, the compulsory nature of the
investment and the lack of diversification in their
portfolio
17
Insufficient equity
• “All over the world, value-adding businesses grow
without having to frequently resort to capital markets
for new equity....”.
• “Fonterra shareholders have already demonstrated
the ability to commit the equity required to fund our
impressive growth and there is no reason to suggest
that cannot continue for the foreseeable future”.
Graham Stuart – Taranaki Daily News, October 2004
18
Insufficient equity (cont’d)
But not consistent with CEO’s comments:
“While Fonterra can fund the immediate needs of the
cornerstone activities and current options within our
existing balance sheet, as the business evolves this
may not always be the case…. ….Any inability to
access sufficient equity could undermine our ability
to realise the full potential of our value-added
operations”
Andrew Ferrier, CEO, Fonterra – 10 June 04 – also repeated same
concern in 2006
19
Insufficient equity
(cont’d)
• Its only options at present are:
– Retentions
– Shares purchased to supply more milk, and
– Inviting existing shareholders to subscribe more
capital
• On a capped base of 13,000 suppliers, this not likely
to generate sufficient capital to fund Fonterra’s
stated objectives
20
1999 Plan
Source: McKinsey
21
2001 Plan
• Promar International commented in 2001 –
“In the initial [1999] merger proposal, it was
suggested that significant external investment would
be needed for the organisation to meet its market
objectives.”
“Our understanding of the [2001] merger proposal [to
form Fonterra] is that the capital requirements are
similar…to undertake the development necessary,
[Fonterra] could decide to bring in outside equity
partners to complete the investment from supplier
shareholders….”
22
Options
• A separate company for the non-commodity
business, controlled by Fonterra but with outside
shareholders
• Non-supplier shareholders in the cooperative
• A public company controlled by the cooperative
• A public company with share in the cooperative, or
• A multi-national cooperative
23
Separate subsidiary
Suppliers
100% votes
Supply rights
Co-operative
Milk processor + seller of
commodities
Constitutional
safeguard
Only go below 51%
with 75% supplier
vote at 2 general
meetings
Minimum
51% votes
Subsidiary
Makes and sells higher
margin (non-commodity)
products
New share capital
49% shares
- tradable
Suppliers + outside investors
by choice, not linked to supply
24
Co-op with
two classes of share
Suppliers
Constitutional
safeguard
Only go below 51%
with 75% supplier
vote at 2 general
meetings
‘A’ class shares
•Supply rights
•100% votes on key issues
Co-operative
New share capital
Milk processor + seller
of commodities
Suppliers + outside investors
by choice, not linked to supply
‘B’ class shares
•Tradable
•Restricted voting rights
An ‘A’ and ‘B’ share structure is used by Air NZ, Livestock Improvement
Corporation and Friesland Coberco (Netherlands)
25
Public company
controlled by co-op
Suppliers
100% votes
Supply rights
Co-operative
Milk processor
Constitutional
safeguard
Only go below 51%
with 75% supplier
vote at 2 general
meetings
Minimum
51% votes
New share capital
Public Company
Operates all businesses
49% shares
•Fully tradable
Suppliers + outside investors
by choice, not linked to supply
This structure was used by Kerry PLC and Glanbia PLC (Ireland)
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Public company
with shares in co-op
Suppliers
Constitutional
safeguard
Only change with
75% supplier vote
at 2 general
meetings
‘A’ class shares
•100% votes
•Supply rights
Co-operative
Milk processor
‘B’ class shares
•Only 1 vote
New share capital
Public Company
Operates all businesses
100% shares
•Fully tradable
Suppliers + outside investors
by choice, not linked to supply
This structure was used by Golden Vale PLC (Ireland)
27
Multi-national co-operative
Aus suppliers
NZ suppliers
Latin American
suppliers
Aus
co-operative
NZ
co-operative
Latin American
co-operative
Aus suppliers
NZ suppliers
Latin American
suppliers
Multinational
co-operative
This structure is used by Arla (Denmark) and MD (Sweden)
28
Cooperative problems
• Widely recognised, even among cooperative
advocates:
– Limited access to share capital
– Weak performance monitoring
– Less efficient decision-making processes
– Diverging expectations among suppliers
– Multiple objectives – lack of strategic clarity
– Lack of capital diversification by shareholders
29
Cross-roads in other countries too
“Co-operatives are at a cross-roads. The future of cooperatives depends on the ability of their leaders to
convince members to structure themselves in order to
compete on multi-commodity, value-added and global
bases”.
M G Lang (1995) – American Journal of Agricultural
Economics
“[In Europe] the co-operative organisation form is in retreat
due to problems of control and transferring market signals”
Torgenson, Reynolds + Gray (1999) – Journal of
Cooperatives
30
Control
• The role of ownership is to gain the ability to
influence decision-making via a direct governance
• It is not total ownership that counts, but control at the
margin
• Ownership control is less of an issue if there is a
market for entering and exiting
• Best for many interested parties (capital markets) to
measure the pros and cons of a company’s
investment plans
• Total closed control (with no trading of shares)
denies shareholders this key benefit
31
Farmers’ challenge
• Too many people in the industry automatically revert
to the 100 year old clichés that involving ‘outside’
investors will only lead to farmers becoming
“marginalised” and “turn their children into peasants”
[Dairy Exporter, July 1997, p 66; see also Nuffield Scholarship reports by Marise James and Catherine
Bull]
• The real challenge for farmers now is to evaluate
these issues with an open mind – to put the old
clichés to one side.
• The idea that markets are in conflict with cooperation
is a serious misconception
32
Value of Kerry shares
1974
1986
2004
100% of Kerry Co-op
51% of Kerry plc
31% of Kerry plc
€1.25 million
€40 million
€1,007 million
Value of members’ investment increased
significantly even though the co-op’s control of
Kerry decreased
33
Exclusive control vs. value
NZ farmers say no to any proposals unless –
• Suppliers keep total control
• No outsider investors take a share, and
• Benefits are shared equally among all suppliers
Result :
– you own 100% of $100 = $100
vs
– 50% of $1,000 = $500
34
Copy Kerry?
Denis Brosnan, Kerry’s highly successful CEO
(retired):
“If one ever wishes to follow the [public company]
route, it will first be necessary to have a change
in philosophy before changing the structure, not
visa versa…”
35
Background slides
36
NZ industry removed competition
Over 100 years, the industry drove out competition in processing and
exporting. It also drove out diversity of ideas, which any industry needs
to realise its full potential. This strategy was based on two misplaced
myths:
• That ‘outsiders’ will reduce suppliers’ wealth, and
• That a single exporter will deliver higher prices for commodities
1900 - 14
Open
exporting
1922 - 25
Open exporting
1914 - 22
Govt controlled
1927 - 34
Open exporting
1926
Single seller
1935 - 2002
Single seller
37
Fear of ‘outsiders’
• “Unity among farmers emerged from their shared distrust of
outsiders” (David Yerex)
• “Dairy farmers developed a suspicion of city and urban
interests...were seeking more than a fair share of his hard-won
livelihood” (Arthur Ward)
• These ‘outside’ interests included virtually everyone beyond the
farm gate: “processors, quality controllers, wholesalers,
distributors, merchants, advertising agents, bureaucrats,
retailers, financiers and tax gatherers” (David Yerex)
38
Faith in cooperative
• “Dairy farmers came to believe - and it was an article of faith that they secured more of the selling price of their produce by
the cooperative method” (Arthur Ward)
• “After a slow start, the concept of the cooperative dairy
company spread like a faith – an extension of the smallholder’s desire for as tight a mastery as possible over his
destiny” (Gordon McLaughlan)
• The culture and values of these pioneering days remain a
strong influence in the modern era (Ward, McLaughlan and Yerex)
39
‘Critical mass’
Promar International’s 2001 view on the minimum scale for global
food companies, with significant dairy in their core activities:
Minimum Size
Fonterra
Total Assets
$67 billion
$11 billion
Employees
180,000
20,000
Revenue
$111 billion
$13 billion
Source: Promar International
40
Returns relative to scale
Return on Shareholders Funds
40
Kraft (2000)
56.7% return on
equity. Total
assets NZ$176b
35
Return on invested funds
30
Nestle (2000)
19.3% return on
equity. Total
assets NZ$87b
25
20
15
Fonterra’s zone
Target 10% return
on equity. Total
assets NZ$11b
10
5
0
Less than 2.2
$2.2 - $33b
$33 - $66b
$67 - $110b
Over $111b
Size of Assets
Source: Promar International
41
No market power
• In basic commodities, Fonterra is ‘price taker’
• Except for a few narrow quota markets, Fonterra has no
significant ability to raise world commodity prices
• Fonterra argues that its international supply chain management
and handling of third party milk products helps smooth some
potential short-term price fluctuations
• However it is clear that Fonterra cannot fundamentally change
commodity prices
42
World dairy rankings (2006)
Company
Country
2006 dairy
sales
(Euros)
2003
2006
1
1
Nestle
Private
Swiss
14.3
2
2
Dean Foods
Private
USA
7.2
9
3
Lactalis
Private
France
7.2
5
4
Danone
Private
France
7.2
3
5
Dairy Farmers of
America
Co-op
USA
7.2
6
6
Fonterra
Co-op
NZ
6.6
4
7
Arla Foods
Co-op
Denmark/
Sweden
6.2
8
8
Kraft Foods
Private
USA
5.2
10
9
Unliver
Private
NL/UK
5.0
11
10
Friesland Coberco
Co-op
NL
4.2
12
11
Meiji Dairies
Private
Japan
3.6
13
12
Campina
Co-op
NL
3.6
Source: Danish Dairy Board
Private firms have
overtaken co-ops to
get places 3 and 4.
Fonterra is standing
still.
43
Examples of co-ops
with shares listed
• Donegal (IR): conversion and stock listing in 1997
• Calavo (USA), conversion in 2001, stock listing 2002
• National Co-operative Dairies / Clover (SA):
conversion in 2003, stock listing in 2004
• Gold Kist (USA), conversion and stock listing in 2004
• Diamond Walnut Growers (USA), conversion and
stock listing in 2005
• IAWS (IR): converted in 2005, plans to become stock
listed in 2006
44
Examples of co-ops with
two share classes
Cooperatives with a separate classes of equity
shares in addition to the traditional ownership rights
held by the member of the cooperative:
• Pro-Fac (USA), in 1994: only preferred stock
• Saskatchewan Wheat Pool (CA), in 1996, nonvoting
common stock
• CHS (USA), in 2001: only preferred stock
45
Examples of co-ops
with separate listed subsidiaries
•
•
•
•
•
•
Kerry (IR), in 1986
Metsäliito / M-real (FI), in 1987
IAWS (IR), in 1988
Avonmore (IR), in 1989 (now Glanbia)
Waterford (IR), in 1989 (now Glanbia)
Golden Vale (IR), in 1989 (in 2001 acquired by
Kerry)
• Atria (FI), in 1991
• LSO Cooperative / HK Ruokatalo (FI), in 1997
• Emmi (CH), in 2004
46
Bibliography
• The comments on control in these slides are drawn from
Bengt Holmstrom, Prof of Economics at Massachusetts
Institute of Technology, in a 1999 paper on the future of
cooperatives
• Example of co-ops with different capital structures –
taken from Bijman + van Bekkum, “Co-operatives going
public: motives, ownership, and performance”,
International Conference on Economics and
Management of Networks – Budapest, 15 – 17
September, 2005
47